August 18th (What is Interest?)

Greetings all,

It is Thursday, August 18th, and the week is almost over. Our subject of discussion today is the nature of interest and the historical origins of the phenomena dating back to antiquity. But first, here are today's headlines in Private Equity and Venture Capital:

Rising interest rates have severely impacted the profitability of consumer lending firms. Finance companies such as?Upstart Holdings?Inc.?and Mosaic lend money to people for purchases such as cars, solar panels, and home electronics. But they have to borrow the money they lend out to consumers, and that is becoming increasingly cost-prohibitive as the Federal Reserve continues?to raise interest rates?aggressively.?As borrowing costs for the companies rise, bad loans are escalating too. With?red-hot inflation?pushing up prices for food and rent, more customers are starting?to fall behind on payments. The lenders’ use of artificial intelligence to identify and pre-qualify large numbers of borrowers quickly made them?attractive among stock and bond investors when markets soared last year, but not for much longer. Investors?have been selling out?of asset-backed bonds issued by the finance companies, and some banks and credit unions have ceasing buying the loans they make. That has elevated funding costs even higher. Shares of?Upstart?and?Carvana?Co., the online used-car dealer that also makes auto loans, are down an average of 80% this year. The financing squeeze is another example of how the Fed’s rate-hiking campaign is impacting all corners of the economy. While these lenders don’t have the size or name recognition of a?JPMorgan Chase & Co.?or a?Bank of America Corp.?, they are an important part of the consumer ecosystem, often lending to borrowers who might not be able to receive loans from traditional lenders. Because they aren’t banks, they can’t fund themselves with deposits. Tighter financing conditions forced the consumer-loan originator Upstart to significantly tighten lending in the second quarter, pushing the company into a quarterly loss. Upstart plans to start using cash reserves to purchase some of its own asset-backed bonds, company executives said on an earnings call last week. “Our mission is to try and bring people who might not seem optically creditworthy through the traditional banking lens into the system,” Chief Financial Officer Sanjay Datta said in an interview. “We’re on a journey of convincing the markets that they can rely on our technology, and we are comfortable stepping in with our balance sheet to provide financing to do it.” The company typically acts as an intermediary, identifying less-affluent borrowers through artificial intelligence and providing them with suitable banks and credit unions for a fee. Upstart began suspending some loans it made on its balance sheet early this year after banks reduced their buying,?but reversed direction?when equity investors reacted adversely. Upstart also arranges loans to be funnelled into asset-backed bonds and sold to investors. But demand for the bonds has weakened, and the extra yield that investors demand to buy them rather than U.S. Treasurys' almost doubled since March to about 300 bps, according to the data provider Finsight. Loans the company currently makes are estimated to yield investor returns of 11% compared with 7% before interest rates started rising, Mr. Datta said. Upstart says it beats competitors at identifying borrowers with low credit scores who won’t default because its artificial intelligence includes nontraditional criteria such as education and employment histories.

In other news, Federal Reserve Bank of St. Louis President James Bullard said Thursday he is leaning towards support for another?large rate rise?at the central bank’s policy meeting next month and added he isn’t ready to say the economy has seen the worst of the inflation spike. “We should continue to move expeditiously to a level of the policy rate that will put significant downward pressure on inflation” and “I don’t really see why you want to drag out interest rate increases into next year,” Mr. Bullard said in a recent interview conducted by the Wall Street Journal. When it comes to the Fed’s next decision on interest rates, Mr. Bullard said of next month’s FOMC meeting that “I would lean toward the 75 basis points at this point. Again, I think we’ve got relatively good reads on the economy, and we’ve got very high inflation, so I think it would make sense to continue to get the policy rate higher and into restrictive territory.” Mr. Bullard is a voting member of the FOMC. Since March, the Fed has commenced an increasingly aggressive path of rate rises to cool inflation from levels that are at?40-year highs. After raising rates from near-zero levels in March, the central bank shifted to 0.75-percentage-point rate increases at its June and July meetings, and now has its overnight target rate in a range of 2.25% to 2.5%. Recent data suggesting a?possible softening in inflation pressures, as well as statements by some central bankers, have sparked a debate among market participants as to whether the central bank can slow the speed of rate hikes into the end of the year. Mr. Bullard said he isn’t ready to say inflation has reached its peak and that it remains important for the Fed to get its target rate to a range of 3.75% to 4% by year-end, before the central bank can decide what it will need to do next year. He also said that he sees an approximately 18-month long process of getting price pressures back to the Fed’s 2% target, and predicted that path will likely be bumpy, while adding, “We’ve got a long way to go to get inflation under control.”

While the Federal Reserve?says it is going to?keep raising interest rates, Wall Street thinks it’s bluffing. This could spell trouble for both of them. Markets pummeled by the?Fed’s rate increases?in the first half of the year are racing upward. The S&P 500 is up 17% from its?mid-June low. The yield on the 10-year U.S. Treasury note, which is used to help set rates on debt such as mortgages and student loans is down more than half a percentage point from its June peak. Even battered cryptocurrencies have jumped. For many investors, the rebound reflects a belief?that inflation has peaked, and expectation that the Fed will shift from raising rates to lowering them sometime next year. A parade of Fed officials has tried to push back. “There’s a disconnect between me and the markets,” Minneapolis Fed President Neel Kashkari said last week. An expectation the Fed will start slashing interest rates in the next six to nine months isn’t realistic, Mr. Kashkari said. It is more likely the Fed will “raise rates to some point, and then we will sit there until we get convinced that inflation is well on its way back down to 2%,” he said. If the Fed proceeds as describes, markets are likely to encounter a painful reckoning, one that could erase much of the recent rally and extend what has been a tumultuous stretch for investors from retail traders to hedge funds to pension funds. “We think the market is getting ahead of itself,” said Wei Li, global chief investment strategist at?BlackRock?Inc. Rising equity and bond prices have loosened financial conditions since the Fed’s June meeting. That works counter to the central bank’s aim to decrease spending and lower inflation by raising rates enough to restrict the volume of money in the economy. “You need to keep financial conditions tight. That’s the whole point of this,” said Marc Sumerlin, a senior economic adviser to President George W. Bush who is now managing partner at economic consulting firm EvenFlow Macro. Any acknowledgment by the Fed that inflation is easing risks catalysing further market gains. That could lead to even looser financial conditions, minimising the central bank’s ability to tame inflation, said Jason Draho, head of asset allocation for the Americas at UBS Global Wealth Management. “Now, you’re sort of undoing a lot of the hard work the Fed has been doing this year to slow the economy,” Mr. Draho claimed.

Elsewhere, Tether Holdings?(the issuer of?the world’s largest stablecoin), said on Thursday it switched the accounting firm that validates its attestation reports to BDO Italia, the Italian member firm of BDO. Stablecoin issuers claim that each token is backed on par with liquid investments. Cash and cash-equivalent investments would allow stablecoin users to redeem their stablecoins in large numbers without causing the collapse of the token.?Tether has long encountered scrutiny over the assets backing its stablecoin. Since at least 2017, Tether has been assuring investors that it will get audited, though it has yet to deliver. In 2021,?Tether and related entities reached an $18.5 million settlement?with the New York attorney general’s office, which alleged that the firm disclosed several public misrepresentations regarding the dollar reserves backing tether. They didn’t elect to comment on such allegations. In February 2021, the firm started to use accounting firm MHA Cayman to offer quarterly attestations, snapshots of a company’s assets held at one moment in time with less rigorous criteria than audits. The? U.K. accounting regulator, the Financial Reporting Council,?is investigating MHA Cayman’s parent company, MHA MacIntyre Hudson,?for its audits of the firm MRG Finance. BDO Italia took over Tether’s quarterly attestations in July. Tether claimed it is working toward releasing monthly attestation records, but didn’t offer a timeline. “Auditors will weigh in on risk management and financial controls. That type of thing doesn’t show up in the attestations,” said Steven Kelly, a senior research associate focusing on financial stability at the Yale School of Management. Mr. Kelly said competitive pressures in the market have forced Tether to become more transparent, but obviously they still aren't transparent enough. “If you are going to be regulated by the market, you have to be 100% transparent,” he said. Concerns about Tether’s reserves increased dramatically after?the stablecoin fell from its $1 peg?to 95 cents on May 12. Investors panicked and redeemed $10 billion in the weeks that followed. Around the same time,?stablecoin terraUSD and its sister token, Luna, collapsed along with nearly $40 billion in value. Tether has since regained its peg and remains the largest stablecoin with a $67.6 billion market capitalisation. It has been?losing market share?to Circle Internet Financial Ltd.’s USD Coin, which has a market value of about $53.3 billion, according to Coindesk.

Finally, a brief discussion on the subject of interest:

Philosophers have long tried to find a rationale for the interest rate existence and determine its value. Aristotle believed that loaned money did not have the ability to increase and should be returned without any interest. The situation is different with the loan of grain for sowing, the quantity of which will be increased. Thus, Aristotle considered the possibility of interest obtaining depending on the form and trend of property use. Also, philosophers have tried to answer the question of "fair" interest rate. At the same time, the usurious interest was considered as unfair a priori. A certain natural percentage was considered as a fair percentage, the value of which should not be high. They considered even the percentage of wood growth in the lemma, equal to 3% per annum. The philosophers tried to reduce economic values to natural values as the basis of the former. The substance of value was revealed in the classical school of political economy, which turned out to be labor. This allowed its representatives to develop the doctrine based on high logic, but it was not possible to reduce the percentage to the cost of labor in it. No substance of value was found in the percentage. They created the theory of interest, which derived the value of interest on the basis of equalising the demand for loan capital and its offer. Two theories of interest have been developed in the economic literature: the theory of money interest and the theory of real interest. The theory of real interest proceeds from the fact that it acts as an equilibrium value necessary to equalise savings and investment, and the theory of money interest sees a special phenomenon in it, inherent in the money economy and which cannot be unambiguously reduced to a direct equation of savings and investment. In addition to these two theories, there are also the ideas about interest as a profit or as a part of a profit. In particular, A. Smith considered interest to be a part of profit, and J.- B. Say - the whole profit. A. Smith, K. Marx and other economists split profit into two components - interest and entrepreneurial income. Nowadays, interest is not included in profit of economics and is considered as a separate specific type of income. The interest rate is the value of money, that is, the fee paid by the borrower for the use of temporarily idle funds. What will the negative interest rate be like then? Here it is necessary to consider two options for the answer, depending on which interest rate is considered - real or nominal. A negative interest rate occurs when the interest rate falls below the inflation rate. In this case, the interest rate does not even ensure the preservation of the borrowed money purchasing power. This may be due to a sharp surge of inflation, the value of which was not considered in the interest rate when money was borrowed. On the contrary, the phenomenon is represented by the situation of the nominal interest rate negativity, when the borrower must return a smaller amount of money than that which he received from the lender. How can this be and what is the point of this for the lender? In practice, a negative nominal interest rate can be set by central banks when accepting money from commercial banks for deposit. The Central Bank ensures the absolute safety of commercial bank funds. In these conditions they are ready to pay for their temporary placement. Keeping money in cash by a commercial bank in its deposit is subject to central bank restrictions and also demands additional costs, including the need for insurance. In the conditions of the economy crisis phenomena, the level of trust in counterparties decreases and the risk of non-return of funds provided to them for temporary use increases. In such conditions, the attractiveness of placing funds in the central bank is growing for commercial banks. During this period, the acquisition of financial or real assets also turns out to be risky due to their value decrease. The central bank turns out to be the only financial institution that is trustworthy among economic agents and the institutions that are willing to pay it to keep funds in their nominal value. The use of negative nominal interest rates by Central banks is considered as unconventional monetary policy. A negative interest rate has limitations and usually does not go beyond minus one percent. It is generally accepted that when a negative interest rate is reached, the economy stimulation based on the use of interest rates exhausts itself, and the transition to the economy stimulation by the money supply expansion also has its limits, since this leads to inflation increase, which gives rise to a set of social-economic problems. The interest rate is traditionally one of the most important instruments of countercyclical economic policy. By manipulating the interest rate, central banks try to exert influence on economic growth stimulation or inflation reduction. When conducting monetary policy, central banks proceed from the assumption that the key (discount) rate can be expansionary, restrictive or neutral. The expansionary nature implies its impact on aggregate demand increase, and, through this, on output increase. To this end, the central bank sets a low interest rate. The restrictive nature is aimed at inflation combat and this corresponds to a high interest rate. The neutral nature of the interest rate means that its value does not have any significant effect on real GDP and inflation rate change. The interest rate here assume a value in the range between the interest rate corresponding to the expansionary policy and the interest rate corresponding to the constrictive policy. That concludes today's discussion on the subject of interest.

I hope you found this article stimulating and edifying in many ways!

With gratitude,

Will